Cartel Inc.owns 35 percent of Elliott Corporation.During the calendar year 2014,Elliott had net earnings of $300,000 and paid dividends of $36,000.Cartel mistakenly accounted for the investment in Elliott using the cost method rather than the equity method of accounting.What effect would this have on the investment account and net income,respectively?

Question

Quizplus · Accepted Answer

Using the cost method rather than the equity method of accounting would lead to an understatement of the investment account and an understatement of net income. In the cost method, the investment account would simply reflect the amount paid to acquire the investment (in this case, 35% of Elliott) and would not be adjusted for the earnings or dividends received. As a result, the investment account would be understated because it would not reflect the earnings of Elliott. In addition, net income would be understated because Cartel would not have recognized its share of Elliott's earnings.